The Relationship Market Structure-Market Efficiency From a Customer Satisfaction Perspective

ABSTRACT - This study extends the applicability of the customer satisfaction construct to the industrial organization arena by exploring its role as a measure of market efficiency. A latent construct methodology is used to explore the link between market structure and market efficiency. A set of testable hypothesis is developed and appropriate methodology is described for testing the structure-conduct-performance paradigm versus the market efficiency paradigm.

Citation:

Lopo Leotte Rego (1998) ,"The Relationship Market Structure-Market Efficiency From a Customer Satisfaction Perspective", in NA - Advances in Consumer Research Volume 25, eds. Joseph W. Alba & J. Wesley Hutchinson, Provo, UT : Association for Consumer Research, Pages: 132-138.

Advances in Consumer Research Volume 25, 1998      Pages 132-138

THE RELATIONSHIP MARKET STRUCTURE-MARKET EFFICIENCY FROM A CUSTOMER SATISFACTION PERSPECTIVE

Lopo Leotte Rego, University of Michigan

[The author would like to thank three anonymous reviewers for valuable comments on an earlier version of this paper.]

ABSTRACT -

This study extends the applicability of the customer satisfaction construct to the industrial organization arena by exploring its role as a measure of market efficiency. A latent construct methodology is used to explore the link between market structure and market efficiency. A set of testable hypothesis is developed and appropriate methodology is described for testing the structure-conduct-performance paradigm versus the market efficiency paradigm.

Results suggest that the structure-conduct-performance paradigm dominates the efficiency paradigm for the analyzed data set. Additionally, a nonlinear relationship between the two constructs is discussed and successfully tested. The rationale of the results is addressed and its implications analyzed.

INTRODUCTION

Expanding the applicability of the customer satisfaction construct can prove to be rather elucidative. Following Fornell’s (1995) findings pertaining the strong empirical relationship between customer satisfaction scoresand extreme negative skewness of those same scores, this study explores the role of customer satisfaction as a measure of market efficiency, using the economic concepts of consumer surplus and efficient resource allocation.

Through the use of these concepts, the relationship between market structure and market efficiency is then investigated. Industry level differences are analyzed and explained via cross-industries customer satisfaction variance. Additionally, two conflicting industrial organization hypotheses: the Structure-Conduct-Performance paradigm and the Efficiency paradigm are tested via a structural equation model with unobservable variables formulation, unveiling a non-linear (quadratic) relationship between market structure and market efficiency.

The role of customer satisfaction and skewness as measures of market efficiency is established. Conclusions for public policy measures and for marketing strategy are discussed. Limitations of this study are addressed and directions for future research are presented.

CUSTOMER SATISFACTION AND MARKET EFFICIENCY

The construct of customer satisfaction has received increased academic interest in the recent past. For the last two decades, several studies have analyzed both the antecedents and consequences of customer satisfaction (Anderson and Sullivan, 1993; Fornell, 1992; Fornell et al., 1996; NQRC, 1994; Oliver, 1980, 1993, Yi, 1991).

According to the majority of these studies, customer satisfaction is usually formulated as the outcome of the consumer’s subjective comparison of expected and experienced product attribute levels (Oliver, 1981) or a post-hoc evaluation of the consumption experience. Several formulations for this post-hoc evaluation exist in the extant literature, ranging from extremely specific formulations based on particular consumption experiences (Oliver, 1980, 1993), to more aggregate formulations based on cumulative consumer experiences (Anderson and Fornell, 1993; Fornell, 1992; Fornell et al., 1996).

Given that the purpose of this study is to explore the role of customer satisfaction as a measure of market efficiency-a macro level indicator-it seems appropriate to use an aggregate level, cumulative specification of customer satisfaction, clearly more apt for measuring aggregate level market efficiency and potentially more accurate (Epstein, 1980). For this study, we define market efficiency using a welfare economics perspective, suggesting it as the outcome of the matching process between consumer’s preferences and firm’s offerings (Fornell, 1995), bringing together the concepts of consumer surplus (Marshall, 1890) and efficient resource allocation.

Despite being a subjective evaluation of cumulative consumer experience, customer satisfaction should reflect the extent to which consumers perceive that expected product attribute levels were fulfilled or not during the consumption experience. This evaluation, although not a direct measure of consumer surplus, was found to be correlated with consumer surplus (Anderson, 1996). Additionally, Fornell and Robinson (1983) provide a rationale for using customer satisfaction as an indicator of market efficiency, by arguing that in competitive markets, firms who are able to satisfy and retain their customers from competitors, are being efficient at matching consumer preferences with their offering, therefore suggesting that high customer satisfaction should reflect increased market efficiency.

A similar argument is used in Fornell’s (1995) empirical generalization, linking high customer satisfaction to increased consumer utility and suggesting that the increased negative skewness of high satisfaction scores should indicate heightened market efficiency. Using a reverse argument, dissatisfied customers would only keep on buying from the same firm if no exit or switching is possible or if the alternatives available are as dissatisfying Both circumstances can be interpreted as indicators of the existence of market inefficiency.

The present sate of science does not allow for the direct measurement of market efficiency and therefore, researchers must define it as a latent construct (Bagozzi, 1980; Fornell, 1982; Fornell, 1995) for which proxy measures need to be found in order to allow for the modeling of the construct. The above argument suggests that customer satisfaction and associated skewness of its distribution can be used as indicators of the higher order and not measurable construct of market efficiency. Therefore, we posit that customer satisfaction and associated skewness are appropriate indicators of the construct of market efficiency.

MARKET STRUCTURE AND MARKET EFFICIENCY

The relationship between market structure (or concentration) and firm performance is surely among the topics that has most fascinated researchers in the filed of industrial organizations (IO). As in many other fields, at least two rather distinct and competing paradigms seem to dominate the way IO researchers have addressed this relationship: the StructurePerformance (SCP) Paradigm and the Efficiency Paradigm.

SCP Paradigm.

Traditional SCP paradigm theorists (Bain, 1951, 1968; Mason, 1939, 1949; Shepherd, 1972; Weis, 1974) argue that the main determinant of consumer welfare is market concentration. The traditional interpretation of the SCP paradigm is based on the proposition that market concentration fosters collusion among firms in the industry. According to this hypothesis, the degree of market concentration exerts a direct influence on the degree of competition among firms. The more concentrated the market, the lesser the degree of competition. According to the SCP paradigm, market concentration is represented by the existence of only a few firms in the market, sharing relatively high market shares. These high market shares are believed to reflect monopoly power, which if exerted will hamper consumer welfare and increases firm performance. SCP supporters suggest that firms in relatively concentrated industries can "afford" to lower the quality of their offerings and/or increase their prices, since they face an almost captive demand. In this sense, SCP theory posits that concentrated market structures create the appropriate incentives for firms to collude and exploit the consumer at the expense of efficiency. Likewise, SCP paradigm implies that less concentrated industries should prevent competitors from colluding by removing most of the incentives for doing so.

Extending the applicability of the SCP paradigm, one can expect that increased concentration, by creating the proper incentives for firms to take advantage of customers and reducing competitiveness, should also lead to decreased efficiency, in a resource allocation sense (e.g. lower quality and/or higher prices).

Efficiency Paradigm.

However, flaws in some of the SCP studies and particular measurement and statistical problems (e.g. concentration and performance measures are usually biased due to improper data aggregation), prompted some authors to develop an opposite rationale, which motivates the efficiency paradigm (Demsetz, 1973; Peltzman, 1977).

According to the efficiency paradigm, market concentration is not seen as the causal effect but rather as the consequence of firm conduct. The efficiency paradigm hypothesis asserts that market concentration is not a random event but rather the outcome of superior firm efficiency. Thus, market concentration is no longer seen as an adverse aftermath, quite on the contrary, market concentration is suggested to reflect the competitive efficiency of the different competitors in a given industry.

The efficiency paradigm introduces a dynamic view of the market structure-firm performance link, suggesting that through strategic decisions, first mover advantages or simply luck, more efficient firms achieve increased market shares, leading to increased market concentration. However, this increased concentration is seen as the outcome of competition and thus contributing to increased market efficiency, using a "survival of the fittest" type of argument (Carlton and Perloff, 1994; Leibstein, 1966; Schmalensee, 1979; Tirole, 1992).

Extending this reasoning, some researchers argue that concentration should not be of concern, rather lack or decreased competition/competitiveness should be of concern.

Recent Developments.

Applied economics has a long tradition of studying and debating which paradigm should apply, in which industries and under what circumstances. Until the late 80’s SCP seemed to be the ruling paradigm, with several researchers (see Gilbert, 1984) finding small but significant positive relationship between market concentration (structure) and firm performance, suggesting that increased concentration drove market efficiency down.

However, improper measurement, data problems and possible confounding of results and variables have prompted Efficiency paradigm researchers to take a lead into isolating what is really driving performance (Smirlock, Gillingan and Marshall, 1984, 1986) and some researchers have found empirical evidence that renders general acceptance to the Efficiency paradigm, suggesting that market structure actually reflects increased firm efficiency and not the other way around. According to some of these studies (see Smirlock, Gillingan and Marshall, 1986), market share was shown to have an impact on firm performance, while concentration was found not to influence performance, clearly suggesting that the Efficiency paradigm holds.

Given these conflicting findings, it is the purpose of this study to identify which paradigm holds for the overall US economy, using a customer satisfaction framework. Additionally, it is also the purpose of this paper to explore cross-industry differences in the results.

HYPOTHESIS DEVELOPMENT

The above arguments suggest that two competing hypothesis can be identified in the extant literature pertaining to the market structure-market efficiency relationship. Assuming that the SCP paradigm holds, then:

Hypothesis 1a: The relationship between market structure and market efficiency should be negative.

Conversely, if we assume that the Efficiency paradigm is the one driving the structure-efficiency relationship, then the alternative hypothesis should hold:

Hypothesis 1b: The relationship between market structure and market efficiency should be positive.

Given that in this study we plan to use a data set that covers roughly 45% of the US economy (in GDP terms), we should expect Hypothesis 1a to hold, since several monopolies are included in the data set and also because cross-sectional data is being utilized, making it easier to capture differences across-industries.

Additionally and in order to better understand these cross industry differences, industry level distinctions are analyzed and non-linear forms for the hypothesized relationship are explored.

A quadratic relationsip between market structure and market efficiency has been suggested before (White, 1976; Bradburn and Over, 1982). The arguments used for explaining such relationship are that as market structure moves from monopoly to loose oligopoly, incentives are created for firms to conduct more efficiently since competition becomes an issue. However, as more firms enter the market and the structure changes from oligopoly to perfect competition, those same efficiency incentives are removed since the marginal contribution of efficiency becomes extremely small, as firms have to face an almost pulverized residual demand. These arguments provide the rationale for the following hypothesis.

Hypothesis 2: The relationship between market structure and market efficiency should be negative and follow an inverted quadratic form.

An additional hypothesis concerning the role of customer satisfaction scores as indicators of market efficiency can also be addressed in this study. Previously we defended the role of customer satisfaction and associated distribution skewness as good indicators of market efficiency. If such is the case, then we should expect both indicators to exhibit appropriate reliability and validity as measures of market efficiency, therefore, the following hypothesis can be stated:

Hypothesis 3: Customer satisfaction and skewness should account for a large percentage of the variance in the market efficiency construct.

DATA DESCRIPTION

The American Customer Satisfaction Index (ACSI) provides the data for customer satisfaction scores and associated skewnesses. The ACSI covers roughly 43% of American economy (in GDP terms), including all major competitors in a wide variety of industries (Fornell et al., 1996; NQRC, 1994). The sectors covered are: Manufacturing-Non-Durables, Manufacturing-Durables, Transportation/Communications/Utilities, Retail, Finance/Insurance, Services and Public Administration/Government. Overall the ACSI surveys close to 200 companies and data for each company is collected via a computer-aided telephone interview of national scope. The demographic characteristics of the approximately 46,000 respondents sampled every year match those of the overall US population. As a whole, the survey was shown to exhibit proper reliability and validity (Fornell et al., 1996). For the present study, company level satisfaction scores [Firm level satisfaction scores are computed using a latent construct methodology and are bounded between 0 and 100. The interested reader is directed to Fornell and colleagues (1996) for a detailed description of the methodology.] for 1995 and the skewness of the distribution of these scores were used as indicators for the market efficiency construct.

For the construct of market structure, 1995 markets shares for all the ACSI firms were used to compute CR₄ and CR₈ ratios and the Hirschman-Herfindahl Index. The methodology used to compute these concentration measures is described in Appendix I. CR₄, CR₈ and HHI are traditional measures of market concentration and have been extensively used, mostly in applied economics, to analyze the relationship between market structure and firm performance (see Carlton and Perloff, 1994 for an recent review). The use of these three variables as indicators of market structure is justified via the obvious association between the three measures. However inherent differences in these measures suggest that they fulfill their reliability role as indicators of a latent construct.

METHODOLOGICAL APPROACH

In order to investigate which industria organizations paradigm holds for the market structure-market efficiency link and in order to explore industry level differences, a structural equation modeling (SEM) formulation with unobservable variables was specified (Bagozzi, 1980; Fornell, 1982). For this specific SEM formulation, market structure and market efficiency were defined as unobservable latent constructs and appropriate indicator variables were used.

Firm level satisfaction scores and skewness statistics for these scores were used as indicators of the unobservable construct of market efficiency. Similarly, CR₄, CR₈ and HHI [CR₄ and CR₈ are computed by summing up the market shares of the largest four and eight firms in an industry, respectively. HHI or Hirschman-Herfindahl Index is the summation of the squared market shares of all firms in the market.] were collected, computed and used as indicators of the market structure construct. The hypothesized model formulation can be depicted in Figure 1.

An confirmatory factor analysis was run on the five indicators and two factors, and an appropriate degree of fit was found. All the indicators loaded significantly on the hypothesized factors and all the loadings exhibited appropriate reliability and clearly validated the factor structure hypothesized.

Given that appropriate reliability and validity was shown to exist in the data set (Fornell et al., 1996), the next step was to effectively run the structural equation model. As mentioned previously, satisfaction scores were empirically found to exhibit strong negative skewness, thus violating traditional normality assumptions. Additionally and since sample size may also be of concern, particularly for the industry level analyses, partial least squares (PLS) estimation technique was used. PLS was originally developed by Wold (1973) and document by Fornell (1992), Lohm÷ller (1989) and Helland (1988). PLS is particularly appropriate for estimating structural equation models with unobservable variables, when data violates traditional statistical assumptions such as non-normality issues.

In order to test hypothesis 1 and 3, we need to analyze the path coefficient b₂₁ and the factor loadings l₁₂ and l₂₂. If the SCP paradigm hypothesis is to hold, then b₂₁ should be negative. On the other hand, for the Efficiency paradigm hypothesis to find support, then b₂₁ should be positive. Concerning hypothesis 3, we would expect both l₁₂ and l₂₂ to be relatively large and significant, for customer satisfaction and skewness to have supporting evidence as indicators of the construct of market efficiency.

In order to address hypothesis 2, we need to explore non-linearity on the relationship market structure-market efficiency. The use of PLS facilitates this, since scores for the latent variables can be obtained and further analyzed. This posterior analysis should provide insights towards the confirmation or denial of hypothesis 2.

FINDINGS

The findings seem to indicate that the SCP model formulation is the one that better describes the relationship market structure-market efficiency. This seems to imply that increased market concentration is usually associated with decreased customer satisfaction scores and decreased negative skewness of the same. These results are summarized in Figure 2.

All the coefficients are statistically significant at a<0.01 and they clearly suggest that the three concentration manifest variables do provide an appropriate representation of the construct of market structure. Likewise, satisfaction scores and associated skewness [For consistency reasons, the sign of the skewness measure wa reversed, in order to have both ACSI and skewness moving in the same direction as the construct of market efficiency, though facilitation interpretation.] do seem to provide a good representation of the Market Efficiency construct. The overall R² measure for the structural equation model is 27.3%. [For PLS, the R² is an appropriate measure of overall fit. Additionally, the estimated deviation correlation matrix can also be used to address overall fit. This analysis also indicates overall fit to be appropriate.]

The importance of this finding can’t be overstated. Although one would expect concentrated industries to lack the incentives to provide appropriate customer satisfaction, the fact that this study finds that to be the case at the national level is extremely relevant and indicates that public policy measures such as the anti-trust Act and industry reulations are still valid today, for the US economy. Additionally, the fact that the association between the two constructs is relatively large (-0.522) suggests that even small increases in market concentration can have potentially harmful consequences in market efficiency.

FIGURE 1

STRUCTURAL EQUATION MODEL

FIGURE 2

RESULTS FOR THE STRUCTURAL EQUATION MODEL

Detailing the level of analysis can provide some meaningful insights. A close examination of the latent variable scores can contribute to identify non-linear association between the two constructs and test hypothesis 2. The corresponding plot can be examined below. Note that the scales are not standardized and they were obtained using the original scales-with locations option from PLS package.

The results clearly suggest a non-linear relationship between the two constructs. Figure 2 also includes a quadratic function fitting the latent variable scores, which seems to provide an appropriate fit (R² is 56%). These findings are in line with previous non-linear relations found by White (1976) and Bradburn and Over (1982).

FIGURE 3

LATENT VARIABLES SCORES PLOT

These results seem to confirm hypothesis 2 and indicate that monopolies exhibit the smallest customer satisfaction of all industries, mostly because they effectively lack the proper incentives to satisfy their almost captive demand.

Moving from a monopoly situation to an oligopolic market structure seems to have important implications in terms of increased market efficiency and customer satisfaction. This seems to be the case for the soft-drinks industry, the apparel-sport shoes industry and the tobacco industry, for which a small but highly aggressive number of competitors fight for an extremely oscillating demand, which must be satisfied in order to be kept.

At the other extreme, as the market structure gets too fragmented and atomized, the marginal benefit for individual firms to be more efficient or to increase customer satisfaction becomes unimportant and we find that decreasing concentration is actually associated with decreased market efficiency and reduced customer satisfaction.

Overall, these results do seem to grant validity to the anti-trust regulations and monopoly rulings that are followed by most governments is modern Western economies and suggest oligopolies as the most efficient market structures.

DISCUSSION AND CONCLUSIONS

This exploratory paper clearly indicates the dominating role of the structure-conduct-performance paradigm on the market structure-market efficiency relationship, using customer satisfaction scores and associated skewness as indicators of market efficiency. These results suggest that increased concentration is usually associated with decreased market efficiency.

These findings are particularly important for public policy measures, as they clearly suggest that concentration per se can be a cause of concern, since it can impact consumer welfare, via decreased market efficiency. However, the results also suggest that perfect competition and extremely fragmented market structures are also not compatible with increased market efficiency, quite on the contrary, since as an industry becomes more and more atomized it also becomes less efficient. The implications for public policy measures seem clear: extreme concerns to have industries that resemble the perfect competition model may actually be unfounded, since market efficiency can actually be reduced by reducing concentration, as Figure 3 suggests.

This study has however, some obvious limitations. First, only limited generalizations can be drawn from the present study, since data for a single year was used. Additionally, some estimation concerns associated with the use of a structural equation model formulation with unobservable variables can be pointed and the use of unobservable variables may make it difficult for the reader to interpret results. Moreover, the fact that only two latent constructs were used eliminates the ability to predict the direction of causaity and therefore, only the correlation or association between the two constructs can in practice be explored. Finally, the potential omission of other relevant variables (e.g. market mobility) limits the applicability of this study.

Nonetheless, strong supporting evidence for the Structure-Conduct-Performance paradigm was shown, the non-linearity of the relationship was uncovered and the role of customer satisfaction as a measure of market efficiency was established.

FUTURE RESEARCH

This exploratory study extends the applicability of customer satisfaction to the Industrial Organizations arena. This is a logical step to perform and by broadening the scope of applicability of customer satisfaction we can hope to better understand the different elements shaping both the antecedents and consequences of customer satisfaction. As an exploratory paper, this piece should be interpreted as a first step towards future research linking customer satisfaction research to industrial organizations research.

Obvious arenas to extend this study include analyzing the moderating role that industrial organization variables have on both the antecedents and consequences of customer satisfaction. Examining how market structure affects the link between customer satisfaction and customer retention or customer complaining behavior, seem obvious extensions for the present study.

APPENDIX I

Alternatively, linking customer satisfaction to firm performance should contribute to extend the applicability of the customer satisfaction construct and should shed some light on one of the most important dilemmas facing today’s business community: should firms focus on satisfying their customers or should firms focus on keeping their customers.

Finally, the development of better measures of market concentration should also prove beneficial for the customer satisfaction framework. Similarly, the inclusion of measures of diversification should allow researchers to better explore the links between customer satisfaction and marketing strategy.

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